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Fallen angels

The fall of star fund manager Neil Woodford highlighted huge industry flaws that left investors high and dry. Dave Baxter reports on a scandal and its consequences
Fallen angels

Loyalty can come with hefty rewards. In the past decade alone, investors who backed the winners of the day – from big tech to the broader US equity market – have made substantial gains by simply continuing to do so. This extends to some of the UK’s most popular active fund managers: Terry Smith and Nick Train are just two names that have made loyal supporters substantially better off over the years.

But any support for the darlings of active management comes with strings attached: much of it is predicated on the idea that investors can get out of a fund as easily as they got in if things go awry.

Nearly six months on from the suspension of the Woodford Equity Income fund, private investors who stuck with the UK’s best-known active manager are counting the cost of their loyalty – even now it still remains uncertain how much money will be recovered once the flagship fund starts winding up in 2020. The Woodford affair has cast a huge shadow over the investment industry, raising questions about trust, transparency and regulation. But it’s an episode that could also help the industry, and investors themselves, avoid future mistakes.


Star falling

Neil Woodford spent decades making his customers much wealthier as a manager at Invesco. A UK large-cap investor with a contrarian bent, he weathered both the dotcom bust and the financial crash by avoiding crowded trades that later proved calamitous. So it was no surprise that when he went solo, launching Woodford Investment Management (WIM), he did so to great fanfare. The firm would run well over £15bn in assets at its peak, with the Woodford Equity Income (GB00BLRZQ406) fund at one point holding more than £10bn.

Initially the main fund, which launched in June 2014, extended a long streak of enviable performance. It returned 16.2 per cent in 2015, vastly outstripping a rise of less than 1 per cent in the FTSE All-Share. Mr Woodford built on his success by launching two more funds: the Woodford Patient Capital Trust (WPCT), which floated in 2015 in what remains one of the sector’s most successful initial public offerings (IPOs), and the yield-oriented Woodford Income Focus fund, which arrived in 2017.

But by 2017 problems had set in. Woodford Equity Income was beset by stock-specific challenges, from the time shares in doorstep lender Provident Financial (PFG) lost two-thirds of their value in a single day to issues at AstraZeneca (AZN). The fund returned just 0.79 per cent that year, while Patient Capital’s share price also struggled.

Performance would not pick up. 2017 saw Mr Woodford stay true to his contrarian roots, making a shift towards more cyclical UK stocks such as Lloyds (LLOY) in the belief that the domestic economy was due a strong comeback. A combination of stock-specific problems and the continued underperformance of domestic-facing sectors saw Woodford Equity Income make double-digit losses in the following two years.

Periodic poor performance is a fact of life for many active managers, but other factors were at work. While Mr Woodford’s listed equity holdings struggled, a chunk of assets invested in unlisted stocks – something highly unusual in an equity income fund – started to represent a worryingly large part of the portfolio. The fund started bumping up against a 10 per cent limit on unquoted holdings, applied as part of the 'undertakings for collective investment in transferable securities' (Ucits) rules that govern a broad swathe of funds sold in the UK.

With the Equity Income fund performing badly and investors starting to grow concerned, outflows racked up. As the table below shows, inflows that had run into the billions went into reverse from 2017.


Woodford Equity Income: estimated net fund flows

YearNet flow

Source: Morningstar. *2019 figures apply to flows until June suspension


This created fresh pressure points for the fund. Some unquoted names did pay off handsomely: Woodford Investment Management offloaded its stake in broker AJ Bell (AJB) before its 2018 IPO, for example.

But because the unquoted holdings generally remained difficult to sell quickly, Mr Woodford would have to sell more liquid stocks as a way of returning cash to redeeming investors. This was not helped by the poor performance of the fund, because any drop in the overall value of the liquid holdings threatened to boost the fund’s allocation to unquoted stocks.

Meena Lakshmanan, partner at wealth manager LGT Vestra, argues that the Woodford strategy went against conventional wisdom, exacerbating his troubles.

“If you have redemptions you need to sell your most illiquid position, not your liquid positions,” she says.

Mr Woodford found himself struggling to stay within the 10 per cent limit on unquoted stocks. The Financial Conduct Authority (FCA) has since noted that it was in touch with the fund’s authorised corporate director (ACD), Link Fund Services, in February and March 2018 because of two occasions where the limit was breached.

Come 2019 and Mr Woodford was taking increasingly desperate measures to stay within this limit. In March, he transferred around £73m of unquoted assets – via stakes in Atom Bank, Carrick Therapeutics, Cell Medica, RateSetter and Spin Memory – from the Equity Income fund to the Patient Capital trust, in exchange for the trust’s shares.

The extreme measures did not end there. Later that same month, it emerged that Mr Woodford had listed some of his unquoted stocks on The International Stock Exchange in Guernsey. This move was widely criticised among industry commentators – and later by the FCA – and Guernsey would later suspend the stocks.

Abi Reilly, managing consultant at Bovill, a consultancy focusing on finance regulation, warns that such moves only served to obscure the difficulties at hand. “He used clever techniques to make something look like a duck, but it was a dog with a plastic beak," she says.

According to data provided to the FCA, around a third of the fund's assets would have taken at least 181 days to sell, as of the end of April 2019. And with a decent chunk of the fund proving difficult to liquidate, redemptions would soon become too great to contend with. The FCA notes that in May 2019, net outflows averaged 1 per cent of the fund's assets a week. But this escalated at the end of the month, as Kent County Council's pension scheme opted to withdraw its investment of around £250m.

"The redemption requests on 31 May and 3 June amounted to £296m, representing 8.6 per cent of net assets, with the fund holding no cash at the time," the FCA said.

While the fund’s ACD, Link, initially hoped to sell enough assets to meet investor redemptions and reopen the fund in early December 2019, it ultimately dubbed this an unrealistic goal, opting instead to wind the fund up and return cash to investors. In mid October, with Link having withdrawn the fund from his control and Patient Capital’s board openly considering a change of investment manager, Mr Woodford served notice on his remaining two funds and took the “highly painful” decision to close WIM.

Investors at least have some clarity about what will happen with their money: Woodford Equity Income starts winding up next year, although some calculations suggest investors will only get a small fraction of their money back. Patient Capital's shareholders have greater hope, in the form of a new investment manager. But it faces significant challenges – as the smaller Income Focus fund will if it is taken over by a new firm, an option currently under consideration.


The fallout

No single issue can explain the Woodford episode. Poor performance in the main fund led many to ultimately rush for the door, and redemptions were partly so great because so many had invested in the first place. This was testament to Mr Woodford’s stellar track record – it is likely that many investors held on for so long because the manager had found himself out of favour more than once before, only to strongly outperform his peers in the end. However, Mr Woodford’s spectacular rise and fall will have far-ranging effects for active managers and those using them.

Some of these problems can and will be addressed, but the Woodford fiasco has made it obvious how poorly equipped open-ended funds are to hold unquoted investments, due to the inherent liquidity mismatch involved (see 'How does fund liquidity work?' below).

These concerns are not limited to unquoted stocks: the investment universe is rife with other illiquid assets, many of which are much more common in open-ended funds. Direct property investments are a good example. Fears about liquidity in the property space looked well-founded earlier this month, when the £2.5bn M&G Property Portfolio fund suspended trading amid "unusually high and sustained outflows". Several open-ended property funds temporarily suspended trading in the aftermath of the 2016 Brexit vote.

Elsewhere, corporate bonds are often the subject of concern. High-yield debt is particularly vulnerable to a drying up of liquidity, some argue.

Smaller listed equities are also a cause for concern, and some UK small-cap investors now run substantial levels of money: four of the funds in the IA UK Smaller Companies peer group run more than £1bn in assets. While not a guarantee of limited capacity, it is worth scrutinising. Large positions in smaller listed equities can be difficult to liquidate without hitting their share prices, as holders of Woodford’s holdings will have felt (see the table at the end of this article).

Elsewhere, an MSCI analysis looking at a sample of large Ucits equity funds found that while the vast majority were very liquid, seven names had more than 15 per cent of assets in illiquid holdings. And Morningstar, the fund ratings agency, recently downgraded Invesco manager and Woodford protege Mark Barnett’s funds in part because of liquidity concerns.

As such it is worth monitoring how big funds are getting when they focus on less liquid assets, and what an investment firm’s view on the underlying liquidity is. Fund firms should, at least, be more forthright on such issues in the wake of the Woodford scandal.

Both the investment industry and the regulator have been spurred into action. Fund managers and other professional investors have been busy assessing how liquidity stacks up in their portfolios.

Those open-ended funds that do still hold unquoted stocks have started to retreat from this area, or at least talk more openly about liquidity management: small and mid-cap funds run by Merian Global Investors sold unlisted stocks to its Merian Chrysalis (MERI) investment trust earlier this year. In the case of Mr Barnett, unquoted investments make up around 5 per cent of assets in his funds, but the manager has argued that liquidity in these portfolios remains strong.

Others who hold unlisted stocks in open-ended funds are few and far between: Merian’s UK Dynamic fund, for example, had a 4.9 per cent weighting to unlisted companies at the end of October, but this is far from the industry norm. Meanwhile, industry bodies have looked for solutions to the liquidity mismatch: the Investment Association (IA), a trade body for asset managers, has proposed a “long-term investment fund”, which could hold illiquid assets but move away from daily dealing.

The FCA has also been busy. Its policy paper on illiquid assets in open-ended funds, whose publication was delayed to consider the implications of the Woodford affair, set out requirements for certain open-ended funds, including some popular property offerings, to suspend trading when there is “material uncertainty” around the value of illiquid holdings.

Other measures could yet emerge: Andrew Bailey, the FCA’s chief executive, has suggested greater scrutiny around professional fund buy lists, for example. Given that many professional investors had fled the Woodford fund well before its suspension, from discretionary fund managers to pension funds, he has also revived an old idea of splitting retail and institutional assets. Meanwhile, the FCA and Bank of England are carrying out a joint probe into the risks of holding illiquid assets in open-ended funds.


Moving forward

All of this could spell a solution. But for many in the industry it falls short of requirements. Ryan Hughes, head of active portfolios at AJ Bell, describes the FCA’s decision not to apply its latest rules to Ucits funds – a large chunk of the open-ended universe – as “a missed opportunity”. He also believes the regulator faces an uphill struggle in changing the behaviour of investors.

“The rules could mean funds suspend more frequently,” he says. “They are trying to take away the stigma of suspensions. The FCA is saying it’s in your interests to suspend, but that’s really hard to sell to investors, even if it’s right.”

Similar limits apply to any fund providers looking to remove the liquidity mismatch in open-ended funds, because asset managers are likely to receive sharp treatment if they abandon daily dealing.

“The problem with daily dealing is that for a fund group, there’s no first-mover advantage to changing from daily dealing to monthly dealing,” Mr Hughes explains. “If you are the lone voice saying that, you can guarantee that people will just switch out of that fund to something that’s daily dealing, because they like the option of that access. If we want movement on daily dealing the only thing that will happen is from the regulator.”

Responses to the IA's idea of a long-term asset fund give credence to his concerns. Interactive Investor, the platform, argued at the time the idea was initially mooted that investors should receive some additional benefit in exchange for less frequent dealing.

Investors have long wish lists when it comes to tackling the liquidity mismatch. This includes the regular publication of a fund’s liquidity profile, detailing how long each portion of assets would take to sell. Another solution would be for the regulator, and investors themselves, to take a closer look at a fund’s capacity, or how much money it can run before liquidity pressures come to bear.

When a fund becomes too big – a subject we discussed in the summer – it can struggle to establish worthwhile positions without owning too much of an asset. In the equity world, this can mean a fund manager inadvertently moving the price – something Mr Woodford has arguably done on both his good and bad days.

Fund managers can take measures to stem the inflow of money, from levying initial charges on new investors to simply dialing back marketing efforts. But Andrew Gilbert, investment manager at Parmenion, believes the FCA and regulator should take a “stronger view” on capacity, with limits on both fund sizes and the workload of investment managers.

“If a manager is well known and everyone buys into them as a star manager, the company launches more funds for them to run. From an investor’s perspective, if that fund had that track record over 10 years but just on one product and now they run 10, clearly they will be more distracted,” he says. “We need more firm boundaries around capacity and the number of mandates they can run.”

Ben Conway, of Hawksmoor Investment Management, argues that a problem lies in funds managers' commercial objectives and how these run counter to those of underlying investors. Because asset managers charge fees on the level of assets they run, it makes sense to allow funds to grow even if this can create issues. He believes investors should look beyond blockbuster open-ended funds.

“The more illiquid the asset class, the more likely you should use an investment trust,” he says. “If you have to go open-ended, pick a small fund.”

However, investment trusts are not without their own problems, as outlined in the box below ('Can investors reduce liquidity risk by using ETFs and investment trusts?', while smaller open-ended funds could charge higher fees and even struggle to survive. Ultimately investors will need to accept that any illiquidity premium they receive is there for a reason.

“What you need to understand if you want to invest is that when you buy illiquid assets for a greater return, there’s a trade-off, and that trade-off is access,” says Mr Hughes.

Patience can also pay off at times: funds run by H2O Asset Management, for example, were subject to liquidity concerns and investor redemptions earlier this year because of esoteric fixed-income holdings. But the funds successfully sold down these positions and never had to suspend trading.

Not all cases of suspension have ended in disaster, either. Open-ended property funds successfully reopened after their 2016 suspension, for example. But come difficult markets, risks remain.

“When you get a bear market, selling £1 of bonds will still be as hard as selling £10m,” says Mr Conway. “When there’s no bid in the market, there’s no bid in the market.”


The Woodford overhang: UK-listed shares

TIDMCompany NameLast share price (p)Price 31 MayShare price since 31 MayWIM holding at 31/5/19Current holding (Link)Liquidation (%)Shares out (m)Market Cap (£m)Remaining stake (£m)
DDDD4D pharma9097.5-8%27.0%20.00%26%65.495711.79
ALMAllied Minds49.579.6-38%28.2%18.20%35%241.3112021.74
AMGOAmigo Holdings59.3248-76%10.0%0.08%99%475.332780.23
ARIXArix Bioscience110.55149-26%24.6%19.80%19%125.614027.49
BABBabcock International*564.255447.826%5.0%0.00%100%505.362,7360.00
BDEVBarratt Developments646.655816%5.1%4.40%14%1012.036,607287.93
BMKBenchmark Holdings484312%12.5%0.00%100%558.912680.00
BBSNBrave Bison1.31.5-13%18.7%0.00%100%612.3480.00
BURBurford Capital805.91665-52%9.4%5.00%47%218.651,77888.11
CARDCard Factory*156.8189.4-17%8.9%0.00%100%341.555370.00
CIRCircassia Pharmaceuticals17.24822-22%28.0%20.00%29%374.646412.92
CSPCountryside Properties372.8302.623%15.0%3.50%77%446.841,67858.30
CRSTCrest Nicholson366366.60%15.1%7.00%54%256.7895465.79
CRSCrystal Amber Asset Management165220-25%16.0%0.00%100%94.611560.00
ESLEddie Stobart Logistics7182.5-14%25.0%20.00%20%377.6626853.63
EVEeve Sleep2.3096.475-64%46.8%19.80%58%260.7461.19
INHCInduction Healthcare117.5119.5-2%14.7%14.70%0%29.63355.12
IPOIP Group5880.2-28%19.0%12.70%33%1059.1461178.02
MERCMercia Asset Management31.3431.30%24.9%11.00%56%303.319410.46
MPHMereo BioPharma3777.5-52%31.2%19.60%37%97.96367.10
MTPHMidatech Pharma3.36.05-45%19.0%16.60%13%469.9152.57
MCLMorses Club*131.2157-16%7.5%0.00%100%130.951700.00
NRRNewRiver REIT184.6210-12%22.3%0.00%100%306.135810.00
NSFNon-Standard Finance26.348.5-46%25.70%4.80%81%312.44813.94
OCIOakley Capital Investments233.08217.57%19.4%0.00%100%202.64720.00
PFGProvident Financial425.9452.2-6%23.4%9.00%62%250.251,06995.92
RAVRaven Property 40.1400%13.2%0.00%100%480.811950.00
RM2RM2 International8.541-79%41.8%8.30%80%40.3430.28
SENSSensyne Health102142.5-28%20.0%11.80%41%128.5713215.47
RUTHRutherford Health227.5227.50%44.9%17.62%61%179.7140972.04
SHHSafe Harbour Holdings132.5132.50%25.8%5.90%77%27.25362.13
TW.Taylor Wimpey170.497165.253%5.1%3.70%27%3265.975,631206.03
TEGTen Entertainment25822017%10.1%0.10%99%651670.17
TMOTime Out1289141%16.1%1.00%94%148.861901.91
TRXTissue Regenix1.175.525-79%26.0%20.00%23%1155.86122.70
TPTTopps Tiles*66.89672-7%5.1%0.00%100%194.961310.00
VERSVerseon Corporation1.549.3-97%21.2%19.50%8%159.6920.47
WJGWatkin Jones222.5215.53%9.2%0.02%100%255.235650.11
XSGXeros Technology1.3097-81%39.7%3.00%92%783.75100.31
Source: companies, Capital IQ, Investegate, Bloomberg, accurate as of 21 Nov 2019. *LFS holdings not listed on Bloomberg, so liquidation assumed.